Prosperity Watch Issue 60, No. 2: Tax swap will erode public investments over time

North Carolina’s reliance on the personal income tax has yielded state revenues that have better kept pace with the long-run growth of the state’s economy and residents’ incomes. Personal income tax revenues have outperformed other, more volatile sources of revenue in growth and have enabled North Carolina to better meet fast-growing demand for public investments and services that include public education, physical and mental health services, and public safety.

This Tax Week, the Budget & Tax Center released analysis of the cumulative impact of recent tax decisions by the Governor and the North Carolina General Assembly which are estimated to reduce revenue by nearly $2 billion annually when fully implemented. These tax decisions have effectively swapped income taxes–by reducing the income tax rates–for sales tax, by broadening the base to more goods and services while keeping the sales tax rate the same.

Replacing the personal income tax with a greater reliance on the sales tax means that North Carolina would lose all the benefit of revenue growth during economic expansions. While revenue from the personal income tax tends to fall faster than the sales tax when a recession hits, the decline is typically from a higher level. Thus, the personal income tax will generally still raise more money than the sales tax.

To illustrate just how damaging the swap to a consumption-based system would be, consider that replacing income tax revenue with sales tax revenue beginning in 1994 would have reduced revenue available for public investments over the next two decades by $13 billion. Even with the slight expansion of the sales tax base to cover more services, the sales tax falls short of keeping pace with income growth and capturing where income growth occurs. Since the wealthiest taxpayers spend less of their income annually and have captured the vast majority of income growth annually, the sales tax alone cannot achieve long-term revenue adequacy to meet the needs of a growing state.

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